Risk management man-Stephen Catlin

Catlin produced a record pre-tax profit before tax of $603m last year against $13m in 2008. This helped deliver a 33% return on net tangible assets against -3% the year before, a 24% return on equity against -2% and 27% increase in net tangible assets per share. This persuaded the group to give an 8% increase in annual dividend. This impressive turnaround was based upon a 12% increase in gross premiums written to $3.7bn on a constant currency basis and 17% increase in net premiums earned $2.9bn on constant currency basis, a combined ratio of 89% combined ratio and a 5.9% investment return for the period against -1.4% the year before. This was followed up by a solid set of interim numbers published for the first quarter that showed a 9% increase in gross premiums written by the group and a 39% increase in gross premiums written by non-London underwriting hubs.hideThe group incurred some big losses in the first quarter. Its estimate of the financial impact of the Chilean earthquake is about $140m, net of reinsurance and reinstatements. The exposure to Windstorm Xynthia that ravaged Western Europe in February reached $5m and the Deepwater Horizon loss will cost Catlin about $40m it is believed. But this was good compared to the first quarter of last year, said the group. “Overall loss experience, with the exception of these catastrophic events, was benign in the first quarter. Large single-risk losses were below average in the first quarter,” it stated. For Mr. Catlin such success can only be achieved if it is built upon sound risk management and an almost messianic determination to ensure that all parts of the business are subjected to a rigorous, ongoing and truly holistic risk management discipline. This is why he is a fan of Solvency II, in principle if not necessarily the way that it has developed since the concept was first introduced. But, he says it can only be made to work for companies if they really do adopt enterprise-wide risk management themselves. “Solvency II only works if you have good enterprise-wide risk management. This is very important and if the industry does not embrace it very willingly then we will all suffer. The concept of ERM is that it goes from top to bottom, from the outside to the heart. You have to learn to communicate better and understand the correlation of all forces. It is therefore really, really good for the industry,” he said. During the World Insurance Forum conference in Bermuda where Mr. Catlin hosted a debate, Neil Currie, CEO of Renaissance Re, said that, in some respects, Europe’s planned new capital adequacy regime will provide some companies with a competitive advantage. Mr. Catlin said that he is not sure that this will be the case, per se. But, he certainly thinks that if it forces insurers to run a better business then it will deliver a competitive advantage to those that adapt the quickest. For this reason the shift to the management of a whole industry based on common standards is a ‘good thing’, not least because it will ‘take out’ those insurers that under-price or under-risk their business, he added. But, and it is a big but, Mr. Catlin said that improved risk management should not be intrinsically linked to higher capital requirements and certainly not to the level that Europe’s leading insurers fear the politicians and regulators appear bent on imposing. “I am an absolute proponent of Solvency II. But, there are two real risks. First is that the European regulators sense an opportunity to overcapitalise the European insurance and reinsurance industry and it will really become under-competitive. During the [WIF] conference Ray Spudek, Chief Economist at the Florida insurance regulator, said that he needs to determine the minimum capital required to honour liabilities to policyholders and is not there to determine the capital required for the company to continue in business. I am of that camp,” explained Mr. Catlin. “The level of capital that must be set is that which is required to meet claims and deliver the promise to policyholders. Credit rating agency capital is set at a higher level, the level required to continue trading forward. This is the economic capital level that asks if you are able to meet a one in one hundred year event. If there are two one in a hundred year events then this is a capital event, the market turns and you can regain your earnings quickly so long as you were able to recapitalise,” he continued. The second big risk posed by Solvency II is that provided by the regulators themselves, according to Mr. Catlin, and many other industry leaders agree with him. He said that most insurance supervisors are very good at regulating legal entities, but, can struggle when faced with cross- border groups. The near-collapse of AIG was much discussed during the WIF conference as speakers focused on the decision by the U.S. government to bail it out and the absence of any indication that it plans to exit the business. Mr. Catlin pointed out that it was not the regulated entities within the group that caused AIG’s problems and any supposed systemic risk. This needs to be understood by the regulators before they start re-writing the rule books partly based on this case, he said. “All regulators have got to get their heads around how they think about groups and, if there are unregulated entities within the group, how they can be accounted for. But, a lot of regulators are within their comfort zone,” he said. Mr. Catlin said that the U.K. Financial Services Authority (FSA), the Bermuda Monetary Authority (BMA) and other authorities are trying hard to grapple with these issues and was keen to stress that it is currently not a ‘them against us’ situation, for Catlin at least. Catlin has for example offered itself as a guinea pig for the FSA and Mr. Catlin said that he is happy for the group to play the role if it helps to find the right solutions for the company itself and the wider industry. Another problem that Mr. Catlin perceives is that some regulators still have national agendas despite the long-term efforts to create the single market. “Germany and France certainly have it in for London. It is a bit like the tax debate and I agree with the speaker at the [WIF] conference who said that this is not really an issue that should be held in public, because it does not really help.” This is an understandable position to take because it helps in such sensitive and often politically charged matters to carry out the horse-trading behind closed doors. But, it also has to be pointed out that the public exposure of such dated national interest activity can only help eradicate it over the long term as customers and voters appreciate the damage done. The creation of a global regulatory framework for the insurance industry would for many in the sector obviate the need for such closed door discussions. This is because there would be little to discuss in public or secret because the playing field would be level and so provide investors and policyholders with the standards needed to make rational judgements on the health of the companies to which they entrust their coverage. Mr. Catlin says that the insurance industry is much easier to understand than it ever was before. But, he would definitely like to see a global system adopted because it would help to ensure that fringe players that destabilise the market would be hounded out, as would Solvency II in Europe. “Yes [a global regulatory playing field] is desirable because it would lead to a level playing field and greater transparency. There is nothing worse than losing a piece of business to a company that is under-capitalised, under-regulated and does not understand its liabilities. You want them to go bust as they did under the old Lloyd’s system. I think global standards and regulation is a very good idea. The level of transparency is so much better than it was and I agree with John Charman [also speaking at the WIF] that the insurance industry has never been in a better state. It is better managed, controlled and regulated and capitalised than ever before. It is not a perfect thing, but, better than ever before.” During the WIF, Jeremy Cox, Head of the BMA, announced that it had just signed a Memorandum of Understanding (MOU) with Switzerland. Mr. Catlin welcomed this news and said that he hopes that it is a sign of a real step towards a more global approach that the industry badly needs. “There is no doubt that the regulators are talking amongst themselves and it will be good if this helps to create a group supervisory regime that works. I do not think we will hit 2012 as the deadline for Solvency II [the EC subsequently revealed an extension till early 2013]. I suspect it will be more like 2015. It will not happen until we have an agreement worldwide about how to regulate global entities and this means we need agreement with the U.S. regulators. This is why it is so important to work with bodies like the Geneva Association,” said Mr. Catlin. While Mr. Catlin is a fan of Solvency II in principle he is not so sure about other major regulatory and legislative moves afoot that will have a direct and significant impact upon the capital of international insurance groups such as the shift to international accounting standards and the current focus on tax, notably by the U.S. government. Insurance company accounts are being affected by many aspects of the International Accounting Standards Board (IASB) project such as revenue recognition, fair value measurement, financial statement presentation, financial instruments, revisions to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, and financial instruments with characteristics of equity. It will also be hit square between the eyes by the planned adoption of a fair value-based accounting standard on insurance contracts planned for introduction next year following the publication of an exposure draft by the end of this month. Like many in the industry, Mr. Catlin says that the mark-to-market basis of the IASB’s project is a ‘nonsense’ that does not work for insurance and will make accounts more not less confusing for users. “Mark-to-market creates volatility and is a nonsense because we can and do hold fixed income securities to maturity and insurance companies are not selling them. A rational person says that this does not make sense,” he said. “Mark-to-market is entirely appropriate when you are looking at cash flow requirements because that is about what you are going to sell today. But, if you can demonstrate that you are going to hold part of the portfolio to maturity it should be accounted for. There is no way that fixed income instruments outside of six months are ever called upon and so they should not be treated on a mark-to-market basis,” explained Mr. Catlin. The rules were introduced for different reasons that were appropriate, but, unfortunately the IASB did not adequately think about how to apply them, he said. “At the end of the day if you have more volatile earnings then this has to be charged to the consumers,” continued Mr. Catlin. Tax is another big topic that has a direct impact on the capital of insurers and their capital management. This is particularly true for those companies based in Bermuda that pay such a low rate of corporate tax and are regarded with envy and even hostility by many rival companies in the United States and to a lesser extent Europe. In 2009 Catlin incurred an effective tax rate of 8.3%. U.S. insurance group W.R. Berkely has led a campaign for some time now to prevent what it claims is unfair competition offered to U.S.-based insurers by the Bermudians that underwrite direct U.S. business but benefit from the light Bermuda fiscal rules. This campaign, led by Congressman Richard Neal in Congress, produced the Neal bill in 1998 which is intended to level the playing field for U.S.-based insurers and prevent tax abuse. The bill, http://frwebgate.access.gpo.gov is titled ‘To amend the Internal Revenue Code of 1986 to disallow the deduction for excess non-taxed reinsurance premiums with respect to United States risks paid to affiliates,’ was referred to the House Committee on Ways and Means on July 30, 2009 and is slowly but surely working its way through the Washington pipework. Not surprisingly, President Obama’s government has looked rather more positively upon this proposal since the financial crisis as it offers some badly needed fresh tax revenue and scores some easy vote-winning political points as a tax on those rich insurers based in sunny Bermuda gorging on the struggling U.S. economy. But, as ever with matters of tax and politics it is of course not that simple. Current U.S. tax law allows U.S. insurance companies (whether U.S. owned or foreign-owned) to deduct reinsurance premiums paid to affiliated or unaffiliated insurance companies based abroad as well as in the United States. But, premiums paid to a foreign-based insurance company are subject to a federal excise tax (FET) at the rate of 1 percent of the gross premiums. This is unless the company is based in a country covered by a double-tax treaty with a waiver provision similar to the treaty the U.S. has with Switzerland or the premiums are ‘effectively connected’ to the conduct of a U.S. trade or business. The U.S. has a limited tax treaty with Bermuda that does not waive the FET. Thus reinsurance premiums paid to affiliates based in Bermuda generally pay the 1% FET. The Neal bill would limit the tax deductibility of reinsurance premiums paid by a foreign-owned insurance company based in the United States to its foreign affiliates, but the same limit would not apply to a U.S.-owned insurance company. Moreover, as Mr. Catlin pointed out, all alien insurers are required under U.S. law to place cash into a fund to cover a claim the moment it is notified already. U.S. companies only have to release the cash when the claim is paid. This has potentially significant cash flow implications and already provides U.S. insurers with a big competitive advantage. Moreover, the addition of another tax on aliens would therefore effectively mean they are double taxed, argue the aliens. And, as the Association of Bermuda Insurers and Reinsurers is at pains to point out, any attempt to further raise the barriers to entry into the U.S. market would be a seriously daft move given that U.S. consumers and industry are so reliant upon international capacity to pay up when catastrophes, and even more run of the mill events, strike. Alien insurers and reinsurers paid some 47% of the total incurred for hurricanes Katrina, Wilma, and Rita to help get the U.S. economy back on its feet. International insurance companies are major providers of earthquake insurance in California and windstorm insurance in Texas, two of the key catastrophe programmes. And, some 13 of the 19 reinsurance companies that report data to the Reinsurance Association of America are foreign owned. That is not to mention the big surplus lines market that provides so much industrial and commercial risk coverage for U.S. industry. And, thirdly it is probably illegal. In a recent policy note published by the Peterson Institute for International Economics, Gary Clyde Hufbauer, Deputy Assistant Secretary for International Trade and Investment Policy of the U.S. Treasury (1977–79), and Director of the International Tax Staff at the Treasury (1974–76) said that he believes such a bill would probably be correctly challenged at the World Trade Organisation. “If the Neal bill…is enacted, European countries are almost certain to bring a case against the United States in the WTO and seek whatever redress they can under U.S. income tax treaties. Some...might consider tit-for-tat retaliatory legislation that would hurt U.S.-owned insurance companies,” he said. Mr. Catlin pointed out that everyone has choices about where they trade and there is nothing to stop you changing your mind, witness Catlin’s relocation to Bermuda from London along with a number of other leading companies plus the recent decision by ACE to relocate to Zurich, XL to Dublin and Flagstone to Luxembourg [See Flagstone feature]. “It really does not matter where you are based so long as you have global reach. W.R. Berkely tried to set up a business here in Bermuda and did not achieve it and so reacted with this tax proposal and this is supported by all national carriers that see this as a mechanism to make it more difficult for people to trade with Bermuda,” he said. “President Obama wants money and he does not need much persuading despite the long term impact on prices paid for insurance by U.S. taxpayers. When you do something like this there is a short term benefit and why should he worry about whether it is good or bad for the U.S. consumer?” he continued. Mr. Catlin explained that the bill has to go to the Senate yet and believes the earliest that will happen will be next year but he does not expect it to disappear under a mound of other legislative initiatives. “It has built up a head of steam now and will not go away. President Obama referred to it in December. There will be a lot of lobbying and it will cause some really strong debate, but, I think it will happen. There will be a reaction and impact on the U.S. insurance industry. Remember half of U.S. reinsurance is bought by U.S. insurers outside of the U.S. and so they need us. Why don’t foreign reinsurers and insurers just capitalise U.S. companies instead? Well the problem is that when you capitalise a legal entity you cannot pull it out. Therefore people will not write a big cheque without thinking about it carefully first,” he explained. On top of this threat from the U.S., Bermuda-based companies also face a significant increase in domestic taxation that emerged out of the blue just before the WIF conference. Mr. Catlin reckons that will cost the Bermuda insurance industry about $75m, adding again to the pressure over the next 12 months. Such external pressures and changes of course simply underline the importance of risk management and the need to take it seriously rather than just pay it lip service and apply it in an enterprise-wide manner said Mr. Catlin. And, this is made even more important by the fast changing risk landscape that groups such as Catlin face from their own customer base as they grapple with emerging risks and seek risk transfer solutions. Major corporate insurance buyers are becoming increasingly frustrated with the apparent inability or unwillingness of the insurers to meet their changing risk transfer needs. The key for Catlin and other insurers is to work harder than ever to try and meet that changing demand. But, they also need to ensure that the underwriters do not stray too far from risks that can be genuinely measured and managed and therefore transferred with a reasonable level of confidence. “Your best client as an insurer reinsurer is one with good risk management. I would rather write well risk managed business at a higher price any day of the week and will make more money that way. We are not here to take trading risk, that is what the customers do and how shareholders make money, and this is something that we have to be careful about,” explained Mr. Catlin. “What we offer is a promise to pay. It is our 25th birthday this year and there is a good reason for this. Anybody can make money for 5 years, but, making money over 25 years and delivering a quality service for customers is very difficult to do. It is not a question of size, you need the ability to run a business over time and take long term decisions and act within your capital capability. I cannot afford to stay in business over the longer term and take risks on that I do not understand or that correlate too closely,” he concluded.

Risk management man-Stephen Catlin

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